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CONCEPT – GOLD STANDARD OF CURRENCY
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- What was it : It was a monetary system where currencies were valued based on a fixed quantity of gold.
- How it worked : The Classical Gold Standard was a system under which some countries "fixed the value of their currencies in terms of a specified amount of gold". They could also link their currency to that of a country which did so. Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold. Gold coins circulated as domestic currency alongside coins of other metals and notes, with the composition varying by country. As each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed. Most countries had legal minimum ratios of gold to notes/currency issued or other similar limits. International balance of payments differences were settled in gold. Countries with a balance of payments surplus would receive gold inflows, while countries in deficit would experience an outflow of gold.
- Three types : These can be - specie, bullion, and exchange.
- In the gold specie standard, the monetary unit is associated with the value of circulating gold coins, but other coins may be made of less valuable metal.
- The gold bullion standard is a system in which gold coins do not circulate, but the authorities agree to sell gold bullion on demand at a fixed price in exchange for the circulating currency.
- The gold exchange standard does not involve the circulation of gold coins, but the government guarantees a fixed exchange rate to the currency of another country that uses a gold standard (specie or bullion), regardless of what type of notes or coins are used as a means of exchange.
- Why abandoned by nations : The necessity of being able to convert fiat money into gold on demand strictly limited the amount of fiat money in circulation to a multiple of the central banks’ gold reserves. Most nations abandoned the gold standard as the basis of their monetary systems at some point in the 20th century, but keep holding gold reserves.
- The Bretton Woods system : It was clear during the Second World War that a new international system would be needed to replace the Gold Standard after the war ended. The design for it was drawn up at the Bretton Woods Conference in the US in 1944. US political and economic dominance necessitated the dollar being at the centre of the system. After the chaos of the inter-war period there was a desire for stability, with fixed exchange rates seen as essential for trade, but also for more flexibility than the traditional Gold Standard had provided. The system drawn up fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar. Unlike the classical Gold Standard, capital controls were permitted to enable governments to stimulate their economies without suffering from financial market penalties.
- A complex system : In theory, international settlement in gold meant that the international monetary system based on the Gold Standard was self-correcting. Namely, a country running a balance of payments deficit would experience an outflow of gold, a reduction in money supply, a decline in the domestic price level, a rise in competitiveness and, therefore, a correction in the balance of payments deficit. The reverse would be true for countries with a balance of payments surplus. This was the so called ‘price-specie flow mechanism’ set out by 18th century philosopher and economist David Hume.
- Adjustment process : This was the underlying principle of how the Gold Standard operated, although in practice it was more complex. The adjustment process could be accelerated by central bank operations. The main tool was the discount rate (the rate at which the central bank would lend money to commercial banks or financial institutions) which would in turn influence market interest rates.
- Gold reserves : A gold reserve is the gold held by a national central bank (like the RBI), intended mainly as a guarantee to redeem promises to pay depositors, note holders (e.g. paper money), or trading peers, during the eras of the gold standard, and also as a store of value, or to support the value of the national currency.
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